Currency Swaps, Financial Arbitrage, and Default Risk

Nilufer Usmen

Financial Management, 1994, vol. 23, issue 2

Abstract: This paper constructs a model for measuring the gains realized by both counterparties to a currency swap that takes place in an international market in which financial arbitrage opportunities exist. Conditions are derived for zero-sum and nonzero-sum outcomes for both default-free swaps and risky swaps in terms of state-contingent interest rate/exchange rate parities. In an imperfect international capital market, swaps with default risk can give rise to greater gains than a default-free swap. Possibility of default, state by state, becomes a screening device for favorable and unfavorable exchange rate outcomes for each counterparty. Thus, the possibility of default, per se, is not the sole determinant of the degree of credit risk in a swap agreement. Covariability of exchange rates and default states plays an offsetting role.

Date: 1994
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